• An investment is an action that creates a cost today but provides benefits in the future.

12.1 An Investment: A Plunge into the Unknown

• Accelerator theory: The theory of investment that says that current investment spending depends positively on the expected future growth of real GDP.

• It postulates that when real GDP growth is expected to be high, firms anticipate that investing in plants and equipment will pay off later, so they increase their total investment spending.

• Procyclical: Moving in the same direction as real GDP.

• Multiplier-accelerator model: A model in which a downturn in real GDP leads to a sharp fall in investment which triggers further reductions in GDP through the multiplier.

12.2 Evaluating the Future

Understanding Present Value

• Present Value: The maximum amount a person is willing to pay today to receive a payment in the future.

• Present Value and interest rates

  • Present value - K/(1 + i)^t

• The present value of a given payment in the future decreases as the interest rate increases.

• When interest rates fall, the present value of a given payment in the future increases.

• The present value—the value today—of a given payment in the future is the maximum amount a person is willing to pay today for that payment.

• As the interest rate increases, the opportunity cost of your funds also increases, so

• the present value of a given payment in the future falls. In other words, you need

• less money today to get to your future “money goal.”

• As the interest rate decreases, the opportunity cost of your funds also decreases, so the present value of a given payment in the future rises. In other words, you need more money today to get to your money goal.

Real and Nominal Interest Rates

• Nominal interest rate: Interest rate quoted in the market.

• Real interest rate: The nominal interest rate minus the inflation rate.

• Real rate = nominal rate - inflation rate

• Expected real interest rate: The nominal interest rate minus the expected inflation rate.

12.3 Understanding Investment Decisions

• Invest in a project if the cost you incur today is less than or equal to the present value of the future payments from the project.

• As interest rates rise, there will be fewer profitable investments in which firms are willing to invest, and the total level of investment spending in the economy will decline.

• Neoclassical theory of investment: A theory of investment that says both real interest rates and taxes are important determinants of investment.

• If the future benefits of the project are not adjusted for inflation, then we should use the nominal interest rate because it takes into account overall inflation-inflation is built into the nominal rate.

Investment and the Stock Market

• Retained earnings: Corporate earnings that are not paid out as dividends to their owners.

• Corporate bond: A bond sold by a corporation to the public in order to borrow money.

• Q-theory of investment: The theory of investment that links investment spending to stock prices.

• Price of a stock = present value of expected future dividend payments

• Firms, like individual investors, rushed to make massive, long-term investments, particularly in the fiber-optics and telecommunications industries.

12.4 How Financial Intermediaries Facilitate Investment

• Liquid: Easily convertible into money on short notice.

• Funds deposited in a bank account, provide a source of liquidity for households because they can be withdrawn at any time.

• Managers are gambling that their vision of the future will come true and make their vast profits.

• Society would not be able to turn its savings into profitable investment projects.

• Financial intermediaries: Organizations that receive funds from savers and channel them to investors.

• These institutions accept funds from savers and make loans to businesses and individuals.

• Savings and loan institutions will accept deposits in savings accounts and use these funds to make loans, often for housing.

• Issuance companies lend the premiums received to earn returns from investments so they can pay off the insurance claims of individuals.

• In normal circumstances, not all households withdraw their money at the same time, so financial intermediaries can lend out most of the money and still have enough on hand to meet withdrawals by depositors.

• By independent, it means the return from one investment is unrelated to the return on another investment.

• Securitization: The practice of purchasing loans, repackaging them, and selling them to the financial markets.

• Leverage: Using borrowed funds to purchase assets.

• Increases in leverage increase the risk that financial intermediaries undertake because they are obligated to pay off the funds they have borrowed, regardless of the actual performance of the assets they have purchased.

When Financial Intermediaries Malfunction

• Bank Run: Panicky investors simultaneously trying to withdraw their funds from a bank they believe may fall.

• Deposit insurance: Federal government insurance on banks and savings and loans.

• As the housing-generated financial crisis spread to the rest of the financial markets, the credit markets essentially “froze” and banks worldwide would no longer lend to each other.

• Financial intermediation does not always work.